Others Present

International Economic Conditions

Data that became available over the past month indicated that the global economy
was continuing to recover. In its April update, the IMF had again raised its
forecasts for global growth. In 2010, this was now expected to be around 4¼ per
cent, which was a little above trend, with a modest strengthening in the subsequent
two years.

While the overall outlook had improved, there remained significant differences
across regions. Growth in Asia remained strong and the focus in those economies
was now on withdrawing policy stimulus to prevent inflationary pressures building.
Conditions were now clearly improving in North America, though Europe remained
weak.

The Chinese economy continued to expand strongly, with growth estimated at nearly
3 per cent in the March quarter and around 12 per cent over the year. While
there had been a slowing in investment spending late in 2009, there had been
a fresh acceleration early in 2010. Housing prices had been growing rapidly,
with particularly strong growth early in 2010. The authorities were taking
a range of steps to cool the market, including increases in the interest rate
and in minimum deposits required for repeat home buyers and investors.

Recent data for other economies in Asia had been strong. GDP data for Korea
had shown growth of nearly 2 per cent in the March quarter and 8 per cent over
the year, and GDP data for Singapore had also been strong. The ongoing recovery
in east Asia was feeding through into broad-based falls in unemployment in
the higher-income economies. Inflation had increased in these economies, but
only modestly so far.

The US economy was continuing to recover, growing by 0.8 per cent in the March
quarter and 2½ per cent over the year. Domestic demand was becoming
a more important driver of growth, with the contribution from the inventory
cycle declining. Equipment investment had risen for a second quarter, although
construction investment – particularly commercial property construction
– had continued to decline. Household consumption spending was growing
solidly.

While the information becoming available on the Japanese economy had been reasonably
positive, data for European economies continued to be fairly soft. The UK economy
had grown modestly in the March quarter, but activity in the euro area appeared
fairly flat. Growth in exports was providing the main support to domestic production.
The most recent data showed that retail sales were still trending downwards,
and uncertainty surrounding Greece's fiscal problems was likely to prolong
this weakness (see discussion below under ‘Financial Markets’).

Domestic Economic Conditions

The major news on the domestic economy had been the further strengthening in
commodity markets and the slightly higher-than-expected inflation data for
the March quarter.

Most indicators of the domestic economy continued to suggest that it was expanding
at a reasonable pace. Although conditions varied somewhat across sectors, business
surveys suggested that business conditions were at relatively strong levels.
Employment was estimated to have grown at a solid pace in March, though growth
appeared to have slowed a little from the rapid pace seen in late 2009. Forward-looking
indicators of the labour market suggested solid growth in the period ahead.
The earlier decline in business credit appeared to have ended and liaison was
providing more indications that banks were looking to boost their lending to
that sector.

Consumer surveys continued to indicate that households were confident about
the future, but that their perceptions about current conditions in the economy
were closer to average levels. Consumption spending had been quite subdued,
consistent with some caution on the part of households, perhaps reflecting
some impact from rising interest rates.

The housing market had remained strong, especially in Melbourne and Sydney.
Nationwide, average prices had grown by around 1 per cent per month in the
first three months of 2010 and auction clearance rates had remained strong
in April. This was despite the fact that housing loan approvals for owner-occupiers
had continued to decline. Members noted the weakness in approvals for home-building
in the high-rise apartment sector, especially outside the capital cities.

The ongoing strength in global, and especially Chinese, steel production was
feeding through into strong demand for steel-related commodities. Contract
prices for iron ore were estimated to have risen by close to 100 per cent in
the June quarter, with spot prices strengthening further since those contracts
had been negotiated. Coking coal prices had recently also risen significantly.

Given these increases in commodity prices, the staff forecast for the terms
of trade had been revised upwards. The terms of trade were now expected to
rise by close to 20 per cent over 2010, boosting nominal incomes by around
4 per cent. In the medium term, the terms of trade were forecast to decline
somewhat, as additional global supply in commodity markets came on stream.
Members discussed the expansionary effects of boosts to the terms of trade
and the experience in some previous episodes.

The staff forecast for growth had been revised up somewhat, partly reflecting
the stronger outlook for the terms of trade. While GDP growth was still expected
to be around 3¼ per cent over 2010, it was expected to pick up
in 2011 and 2012 to be in the 3¾–4 per cent range. Growth in private
demand was expected to strengthen through this year. A very large increase
in engineering investment was forecast, and business investment (excluding
livestock) was expected to rise to its highest share of GDP seen in the five
decades of quarterly national accounts. As a result, the capital stock was
expected to continue to grow at a high rate. Growth in household consumption
was expected to be somewhat below the rate seen in earlier periods of strong
income growth, with a gradual rise in the saving rate.

Members discussed the March quarter inflation data, which showed that underlying
inflation had continued to fall in year-ended terms. However, the quarterly
increase in prices was slightly higher than expected at the time of the February
Statement on Monetary
Policy. Underlying inflation was around
0.8 per cent in the quarter and 3 per cent over the year.
CPI inflation was also close to 3 per cent. The prices of tradable
items (excluding fuel and food) had fallen in the quarter, reflecting discounting
by retailers, the sharp exchange rate appreciation during 2009 and tariff cuts
that had taken effect in January. In contrast, non-tradables inflation (excluding
deposit & loan facilities) had picked up to a year-ended rate of 4.4 per cent,
with significant increases in the prices of housing-related items, most notably
utilities.

Reflecting recent developments in inflation and the stronger outlook for the
economy, the staff forecast for inflation had been revised up a little. Underlying
inflation was now expected to fall to around 2¾ per cent over
2010, compared with the forecast of 2½ per cent in February. It was
then expected to trend gradually higher to around 3 per cent over 2012.
CPI inflation was expected to be somewhat above underlying inflation in 2010,
in part because of the large tax-driven increase in the price of tobacco.

Financial Markets

Members spent considerable time discussing the financial problems facing the
Greek Government, the resulting turmoil in financial markets and the implications
for the global economy. The key facts were: Greece's sovereign credit
rating had been downgraded by all three rating agencies; details of a financial
assistance package from euro area governments and the IMF had now been finalised;
and the European Central Bank had decided to suspend its collateral standards
to ensure that Greek debt remained eligible in its repurchase operations. The
announcements had not calmed markets; spreads on Greek government debt had
widened further and the market in Greek debt had become dysfunctional.

Members discussed the serious challenges the Greek authorities faced in order
to overcome the current financial difficulties. The large fiscal consolidation
required over the next several years was likely to lead to a serious economic
contraction. Members considered the risk of contagion to other countries in
Europe and noted that the sovereign debt of Spain and Portugal had also been
downgraded. However, to date, the problems in debt markets had been predominantly
confined to Europe, though global equity markets and exchange rates had been
affected.

Yields on 10-year government debt had fallen in the major countries, including
those in the larger countries of the euro area following a flight to quality.
Australian government bond yields had also fallen slightly. Emerging market
sovereign debt spreads had been largely unaffected by the crisis in Greek public
finances, apart from rises in spreads on debt of emerging European economies.
There had been virtually no effect on corporate bond markets, where market
conditions were still improving and the default rate on speculative grade debt
had declined from its peak reached in 2009.

World equity markets had reached a 19-month high during April, bolstered by
better-than-expected first-quarter earnings results, particularly in the United
States, before being affected by the deterioration in the situation in Greece
towards the end of the month. Greek share prices had fallen sharply over the
past month, with banking shares particularly hard hit. Uncertainty over the
effect of policy tightening by the Chinese authorities had led to a significant
fall in Chinese share prices.

Turning to foreign exchange markets, members observed that the euro had depreciated
further over the past month, but currency markets overall had been fairly calm.
The US dollar had appreciated in trade-weighted terms, reflecting its rise
against European currencies, but had depreciated against a range of Asian currencies.
It was slightly lower over the year in trade-weighted terms. Over the past
month, the Australian dollar was little changed against the US dollar, had
reached new highs against the euro and had appreciated moderately on a trade-weighted
basis. It was almost 20 per cent higher over the past year.

Australian banks had issued a relatively small amount of bonds in April following
the large amount of issuance in recent quarters, which had put their funding
on a good footing. There had been continued strong Kangaroo bond issuance over
the past month.

Competition among the banks for deposits had levelled off somewhat over recent
months, with rates on term deposit specials flat since the end of 2009, albeit
at high levels relative to other interest rates. The increase in the cash rate
in April had been passed through to intermediaries' lending rates in
full. Housing and business lending rates were now a little below the average
of the past decade and a half.

Monetary policy had been tightened in several emerging market economies over
the past month: in India, the repo rate and reserve requirements had been raised;
in China, the reserve ratio on banks was lifted further and a range of other
measures tightened to curb property price inflation; and there had also been
policy tightening in Brazil. The Monetary Authority of Singapore announced
that it would allow the exchange rate to appreciate as a means to tighten policy.
Expectations were for tightening in Canada and New Zealand around mid year,
but any tightening in other major countries was not expected before the end
of the year.

In Australia, expectations of a further rise in the cash rate at this meeting
had strengthened following the release of the CPI for the March quarter.

Considerations for Monetary Policy

In considering the stance of monetary policy, members noted that, even though
the global recovery continued to be uneven, the overall pace of global growth
this year was likely to be at least average. Importantly for Australia, Asia
was expanding strongly. There had been further sharp increases in commodity
prices and it was likely that Australia's terms of trade this year would
recover to the high levels reached in 2008. This would provide a large boost
to nominal income.

At present, the domestic economy appeared to be growing at an around average
pace, although conditions varied across sectors of the economy. Retail spending
was relatively subdued but investment was strong. New housing loan approvals
had slowed but the overall pace of housing credit growth remained solid. Credit
conditions for parts of the business sector were starting to improve. The latest
forecasts suggested that domestic output growth was likely to strengthen further
over the next couple of years, with the expansionary effects of the rise in
the terms of trade more than offsetting the scaling back of fiscal and monetary
stimulus. Labour market conditions were expected to continue to tighten gradually.

Members noted that the latest inflation numbers were a little above the expectation.
Even though inflationary pressures in the traded sector had been held in check,
partly owing to tariff cuts and the appreciation of the exchange rate, there
had been strong rises in the prices of many services, which suggested that
these sectors of the economy were operating with limited spare capacity. The
forecast for inflation had been revised up, and over the next couple of years
it was likely that inflation would not be much below the top of the target
range.

Members spent considerable time discussing the disturbances in financial markets
arising from concerns about sovereign debt in parts of Europe, with their focus
particularly, but not only, on Greece. The measures of financial support for
Greece so far announced had not managed to calm markets. There was a risk that
the situation could worsen further, damaging the global economic recovery.
However, while there had been some decline in global equity prices and some
impact on exchange rates, so far at least there had not been significant contagion
to debt markets outside Europe; the direct impact of Greece on Australia was
considered to be small. The timeframe over which developments might play out
was not clear, and it could be some time before the uncertainties were resolved.

Members noted that the increases in interest rates to date had been timely.
There were some early signs that they were beginning to affect behaviour, with
retail sales subdued and housing loan approvals falling noticeably. Nonetheless,
the stimulatory effects of the resources boom would be building over the year
ahead. Members were conscious of the need for this not to result in a material
worsening in the medium-term outlook for inflation. This was weighed against
the case that could be made for a pause in the process of normalising interest
rates owing to the uncertainty in the euro area. On balance, members judged
it to be prudent to undertake some further monetary tightening at this meeting.
They noted that, if lenders responded as expected to another rise in the cash
rate, interest rates faced by most borrowers would then be at around their
average levels over the past decade. Members felt that this would leave monetary
policy well placed for the present. The Board therefore supported another rise
in the cash rate.

The Decision

The Board decided to raise the cash rate by 0.25 percentage points to 4.5 per
cent, effective 5 May.